What are smart-beta ETFs and how do you trade them?

What are smart-beta ETFs?

A smart-beta ETF is a kind of exchange-traded fund with a rigid rules-based system. It uses this system for selecting investments to be included in the 'basket of securities' within that fund. This is different from a standard ETF, which simply tracks an index such as the FTSE 100.

A smart-beta ETF is in some ways an improvement, as it will tailor its constituents within the fund's holdings based on pre-set financial metrics.

What is a smart-beta ETF strategy?

To start with, it’s important to understand how the components of a standard ETF are selected. While there are thousands of ETFs covering hundreds of asset classes, almost all allocate different weightings to the different assets within the ETF. For example, in an FTSE 100 index tracker ETF, the larger FTSE 100 companies such as Shell or AstraZeneca are given a larger weighting to maintain alignment with the index.

This is known as market-cap weighting, where companies are selected based on their market capitalisations (share price x number of shares). So if a company rises in value, it will see its weighting – and therefore its influence – over the ETF's performance increase.

Smart-beta ETFs do not use this typical market-cap weighting method alone. They also consider specific elements that only occur within a company or sector to make 'smarter' allocations. These factors include metrics such as momentum, earnings growth, profitability or even social media sentiment. Each smart-beta ETF has its own rules designed as part of a systematic approach to picking assets to be included in the fund.¹

Accordingly, all smart-beta ETFs adopt elements of both passive and active investing. This is because they are invested in an underlying passive strategy, such as following a major index. This is then improved by considering the above alternative factors, which narrows down the selection of assets held in the fund.

Some investors consider that smart-beta ETFs represent the 'best of both worlds', though it's worth noting that many investors prefer to stick to the standard ETF.

Types of smart-beta ETFs

All smart-beta ETFs use their own factors to screen an asset before allocating capital. One common aim is to invest in companies with reliable dividend distributions that are likely to increase over time. Others might invest in stocks with low volatility to reduce risk and make the fund more suitable for short-term investing.

While there are many different types of smart-beta ETF strategies, the four most well-known variants are:

Equally weighted

A standard ETF usually weights the fund through the stock price and overall market capitalisation of each asset. An equally weighted smart-beta ETF, however, will grant 'equal weight' to each holding and its own specialised factors. For example, an FTSE 100 equally weighted smart-beta ETF would allocate 1% of the fund's capital to each of the 100 companies in the index.

Fundamentally weighted

This strategy involves weighting the fund's asset allocation by considering factors like total earnings, revenue, profits and other financially driven metrics. This tactic is often less risky but also ignores investor sentiment and the psychological element.

Factor-based weightings

This approach weights stocks in the smart-beta ETF only based on specific factors, such as underpriced valuations, balance sheet strength or their ability to grow. Different factors will deliver different returns depending on the market's point in the economic cycle, so these types of ETFs tend to fall in and out of favour.

Low-volatility weightings

This is a popular risk-weighted methodology that focuses on assets with historically low fluctuations in price. As an example, an FTSE 100 low-volatility weighted smart-beta ETF might only invest in the 50 least volatile stocks in the index.

This usually translates to less risk but also sacrifices the potential for increased capital growth elsewhere. Further, low-volatile stocks are often in higher demand, so they can be overvalued on fundamentals.²

How to trade smart-beta ETFs

1. Create an account or log in
2. Choose CFDs and search for your smart-beta ETF opportunity
3. Select 'buy' to go long or 'sell' to go short
4. Set your position size and take steps to manage your risk
5. Open and monitor your position

When you invest in smart-beta ETFs, you buy the fund and own shares in it. You profit when the share price rises and from any dividends it may pay. Trading, on the other hand, is leveraged. You open the position with a deposit (called a margin), which is a fraction of the total trade size. This means you can gain or lose money very quickly, and you could even lose more than your initial deposit.

Learn more about the differences between trading and investing.

New to investing and trading? Open a demo account to build your confidence.

Top smart-beta ETFs to watch

Some of the most popular smart-beta ETFs include:

1. iShares Russell 1000 Growth ETF – seeks to provide similar returns to the Russell 1000 Growth Index. The fund's factors include a focus on three fundamental considerations: price-to-book, medium-term growth forecasts and sales-per-share growth ³
2. Vanguard Value Index Fund ETF – tracks the CRSP US Large Cap Value Index. Its benchmark is determined by several factors, including forward price-to-earnings ratios, price-to-book and historical dividend yield
3. Vanguard Dividend Appreciation Index Fund ETF – aims to return similar results as the NASDAQ US Dividend Achievers Select Index. The fund selects companies that have increased dividend payments over the past decade, then weighs these by market capitalisation

Pros and cons of smart-beta ETFs

As with all investing strategies, smart-beta ETFs come with their own set of unique advantages and drawbacks. Remember, an ETF is only as good as its underlying investments, and past returns are no guarantee of future performance.

Pros of smart-beta ETFs

• Smart-beta ETFs are often designed to increase returns, maximise dividends and lower risks compared to a standard ETF equivalent, as they are based on pre-selected historically proven factors
• These kinds of ETFs offer a blended active/passive investing approach that can yield higher returns rather than using just one or the other
• They allow for more targeted investing for your goals and risk attitude compared to standard ETFs
• Ignoring the typical market-cap weighting stops the largest companies on an index from having an outsized influence on their performance
• Smart-beta ETFs have higher expense ratios than traditional ETFs but often deliver better returns and are far cheaper than actively managed funds
• These types of ETFs are often geared towards minimising risks while maximising returns, while a standard ETF simply follows an index
• Some smart-beta ETFs allow for flexibility, including higher-risk holdings that can deliver a better chance of outsized returns
• They are very transparent, as investors can see the assets held within the fund in addition to its weighting formula. This compares favourably to the opacity of some actively managed funds

Cons of smart-beta ETFs

• Smart-beta ETFs are a relatively new phenomenon, so some suffer from low volume and liquidity. This can make it hard to exit a position
• Some smart-beta ETFs can be relatively expensive, as stocks have to be repeatedly bought and sold to meet the fund's rules
• Trading costs and fees may be lower than in an actively managed fund, but the increased costs compared to a standard ETF can bite into returns over time
• These kinds of ETFs can underperform a traditional index they have adapted, such as the FTSE 100. If better returns were guaranteed, the traditional alternative would not exist
• As some smart-beta ETFs consider multiple factors for asset inclusion, it can be difficult to understand what you're investing in compared to a standard ETF
• Many have only been in operation for a few years and therefore have a limited track record. Meanwhile, a traditional index fund such as the FTSE 100 has proven returns over the long term
• Small tracking errors are common, as smart-beta ETFs regularly deviate slightly from their underlying index or investment objective

Smart-beta ETFs summed up

• A smart-beta ETF is a kind of exchange-traded fund that uses a rigid rules-based system for selecting investments to be included within the 'basket of securities' within that fund
• This type of ETF adopts elements of both passive and active investing
• There are many different types of smart-beta ETF strategies, but the four most well-known variants are: equally weighted, fundamentally weighted, factor-based weightings and low-volatility weightings
• Smart-beta ETFs have higher expense ratios than traditional ETFs, but they often deliver higher returns and are far cheaper than actively managed funds
• Improved returns are not guaranteed, and smart-beta ETFs usually require more investor research than their standard alternatives

Sources

1. Smart Beta ETF - Overview, Strategies, Advantages – Corporate Finance Institute
2. Smart Beta ETF List – VettaFi
3. iShares Factor ETFs – BlackRock